Transmission mechanism of monetary policy in India

Abdul Aleem*
Centre deconomie de lUniversite Paris Nord (CEPN), University of Paris XIII, 99 avenue Jean Baptiste Clement 93430 Villetaneuse, France
1. Introduction
Monetary policy affects the real sector at least in the short run, and monetary policy decisions are transmitted to the real
sector through different mechanisms. These mechanisms differ fromone country to another depending upon their legal and
nancial structures. Since the beginning of the 1990s, analysis of monetary transmission mechanisms in emerging
economies has gained substantial importance due to structural and economic reforms and subsequent transitions to new
policy regimes. However, these economies have specic characteristics that differ from those of industrialized countries.
Monetary policies in emerging economies are constrained by the worlds major central banks, i.e., the Federal Reserve
Bank, the European Central Bank and the Bank of Japan. Hence, the analysis of monetary transmission mechanisms in
emerging economies requires a model specication different from that of developed countries. A model misspecication
may bias the results. The so-called price-puzzle is one of the consequences of model misspecication (Sims, 1992).
Previous empirical studies concerning monetary transmission mechanisms in emerging countries have established the
importance of the bank lending channel. However, it is possible that the entire change in aggregate demand after a monetary
policy shock occurs via the traditional money channel. Whether the effects of monetary tightening pass through the bank
lending channel and not through the traditional money channel remains to be shown.
Central banks in emerging economies stabilize exchange rates.
1
A exible exchange rate regime in these economies
resembles a de facto peg. Since these economies are characterized by underdeveloped nancial markets, their central banks
intervene in foreign exchange markets to stabilize exchange rates. This phenomenon is often explained by the hypothesis of
fear of oating (Calvo & Reinhart, 2000). Given this specic behavior of central banks in emerging economies, a better
Journal of Asian Economics 21 (2010) 186197
A R T I C L E I N F O
Article history:
Received 6 June 2008
Received in revised form 30 September 2009
Accepted 2 October 2009
JEL classication:
E44
E52
E58
Keywords:
Monetary transmission mechanism
Bank lending
India
A B S T R A C T
This paper examines the transmission mechanismof monetary policy in India. Considering
the external constraints on monetary policy, it estimates a series of vector autoregression
models to examine the effects of an unanticipated monetary policy tightening on the real
sector. The empirical results suggest that the lending rate initially increases in response to
a monetary tightening. Banks play an important role in the transmission of monetary
policy shocks to the real sector.
2009 Elsevier Inc. All rights reserved.
* Tel.: +33 149403530; fax: +33 149403334.
E-mail address: aleem.abdul@univ-paris13.fr.
1
For more details, see Calvo and Reinhart (2000), Reinhart and Rogoff (2002), Levy-Yeyati and Sturzenegger (2005).
Contents lists available at ScienceDirect
Journal of Asian Economics
1049-0078/$ see front matter 2009 Elsevier Inc. All rights reserved.
doi:10.1016/j.asieco.2009.10.001
understanding of monetary transmission mechanisms requires an analysis of not only the response of aggregate demand,
but also the response of the exchange rate to a monetary policy shock.
In the post-reform period, the Reserve Bank of India has adopted market-oriented monetary policy instruments and
operating procedures. In the new monetary policy framework, issues related to monetary transmission mechanisms have
gained much importance. Some studies have examined specic transmission channels of monetary policy in India.
2
Since
these studies suffer from the above-mentioned aws, by taking into account these observations and providing a
comprehensive empirical analysis of monetary transmission mechanisms in India, we hope that our work will have
important implications for an emerging economy. In this paper, we examine three channels of monetary transmission in
India: the bank lending channel, the asset price channel and the exchange rate channel.
The paper proceeds as follows. In Section 2, we review the previous work on monetary transmission mechanisms. In
Section 3, we propose a benchmark vector autoregression (VAR) model in order to estimate the dynamic responses of GDP,
prices and interest rates to an unanticipated monetary policy tightening. In Section 4, we augment the benchmark VAR
model to examine the transmission channels of monetary policy and examine the robustness of our results. We conclude in
Section 5.
2. Literature review
In order to examine the bank lending channel in the United States, Bernanke and Blinder (1988) expanded the standard
IS-LMframework by including the bank loans market. Since the beginning of the 1990s, Vector Autoregression (VAR) models
have become a widely used tool for analyzing monetary transmission mechanisms. Bernanke and Blinder (1992) examined
monetary transmission mechanisms in the United States. They found that monetary policy works partly by affecting the
composition of bank assets. Christiano, Eichenbaum, and Evans (1998) showed that the effects of an unanticipated monetary
policy shock in the United States are completely transmitted to output, consumption and investment in eighteen months.
Peersman and Smets (2001) demonstrated that an unanticipated monetary tightening tends to be followed by a real
appreciation of the exchange rate and a temporary fall in output in the euro area. They showed that prices are more sluggish
and fall signicantly belowzero several quarters after the decline in GDP. Morsink and Bayoumi (2001) found that banks play
an important role in transmitting monetary shocks to real activity in Japan. Suzuki (2004) discussed the supply versus
demand puzzle to examine the credit channel in Japan. He found evidence of the credit channel and showed that an
unanticipated monetary policy shock is followed by a permanent increase in land prices.
A limited number of empirical studies have examined the monetary transmission mechanisms in emerging economies.
Disyatat and Vongsinsirikul (2003) examined the monetary transmission mechanism in Thailand and demonstrated the
importance of the bank lending channel. Pandit, Mittal, Roy, and Ghosh (2006) estimated a structural VAR model to examine
the bank lending channel in the post-reform period in India. They showed that small banks are more severely affected by
monetary tightening than large banks. However, Al-Mashat (2003) found that banks play little role in transmitting monetary
policy shocks to the real sector in India. He concluded that the impact of a monetary policy shock on macroeconomic
variables is larger after including the exchange rate in the model. An empirical study on monetary transmission in India
showed that a positive shock to broad money leads to higher output, while a positive shock to the overnight call money rate
produces the opposite effect (Reserve Bank of India, 2003), demonstrating the existence of a narrow credit channel in India.
Prasad and Ghosh (2005) examined the relationship between monetary policy and corporate behavior in India. They
observed a strengthening of the interest rate channel after 1998. Singh and Kalirajan (2007) concluded that interest rates
play an important role in the monetary transmission mechanism in the post-reform period in India. Ahmed, Hastam, Asif,
and Yasir (2005) examined different monetary policy channels in Pakistan and demonstrated the importance of the bank
lending and interest rate channels.
3. Benchmark model
3.1. Benchmark identication scheme
We employ the VAR approach to examine the effects of an unanticipated monetary policy tightening on GDP, prices and
overnight call money rate. The VAR approach takes into account the simultaneity between monetary policy variables and the
real sector. We identify the benchmark VAR(p) representation as follows:
X
p
i0
F
i
Y
ti
QX
t
e
t
(1)
where Y
t
is the vector of endogenous domestic variables and X
t
is the vector of exogenous foreign variables. F and Q are
polynomials. e
t
is the vector of structural innovations. The rationale for including the vector of exogenous foreign variables is
to take into account external constraints and to control for international economic events. We assume that the exogenous
2
Al-Mashat (2003), Pandit et al. (2006), Reserve Bank of India (2004), Prasad and Ghosh (2005).
A. Aleem/ Journal of Asian Economics 21 (2010) 186197 187
variables have contemporaneous effects on the endogenous variables and that there is no feedback effect from endogenous
variables to exogenous variables.
Monetary policies in emerging economies are constrained by the worlds major central banks, i.e., the Federal Reserve
Bank, European Central Bank and the Bank of Japan. Central banks in emerging economies take into account the foreign
variables to set the policy rates. These economies are indebted in a foreign currency, e.g., the US dollar or the euro. Default
risks can aggravate if the central banks in these economies let the exchange rates uctuate freely. Similarly, foreign trade in
these economies is primarily invoiced either in US dollars or euros. Thus, abrupt exchange rate variations in these economies
are harmful for foreign trade. For these reasons, the central banks in emerging economies stabilize exchange rates even
though they announce that they do not do so. In order to examine the exchange rate policy of the Reserve Bank of India, we
compare the spot rates and volatility of the Indian rupee versus the US dollar and the euro with that of the US dollar versus
the euro. The left panel of Fig. 1 depicts the spot rates of the Indian rupee versus the US dollar (INRUSD), the Indian rupee
versus the euro (INREUR) and the US dollar versus the euro (USDEUR). We nd that INRUSDhas remained within the limit of
4349 rupees per US dollar during the whole period, while INREUR and USDEUR have changed signicantly.
The right panel of Fig. 1 depicts the currency volatility
3
of three spot rates. We nd that the INRUSD volatility (VINRUSD)
remains very lowas compared to the volatilities of other spot rates. If the INRUSDis a xed rate, every change in the USDEUR
will change the INREUR. Hence, INREUR volatility (VINREUR) will be similar to USDEUR volatility (VUSDEUR). In the right
panel of Fig. 1, a strong correlationbetween VINREUR and VUSDEURsuggests the Reserve Banks policy to stabilize the Indian
rupee vis-a` -vis the US dollar. When a central bank stabilizes the exchange rate, its policy rate follows the foreign interest
rate, i.e., the policy rate of the anchor currencys country. Fig. 2 depicts the evolution of the overnight call money rate and the
federal funds rate from 1998 to 2006. The overnight call money rate follows almost the same path as the federal funds rate.
Similar movements of the two rates suggest that the Feds monetary policy is an external constraint on Indian monetary
policy. Therefore, we include the federal funds rate in the vector of exogenous variables.
We also include the world commodity prices and the GDP of the United States in the vector of exogenous variables to
control for changes in world ination and demand. Thus, the vector of exogenous foreign variables consists of the world
commodity price index (Compi
World
), federal funds rate (i
us
) and GDP of the United States (y
us
).
X
0
t

Compi
world
i
us
y
us
h i
The vector of endogenous domestic variables consists of gross domestic product (GDP), index of domestic prices (Prices)
and an indicator of the monetary policy stance (i).
Y
0
t
GDP Prices i
3.2. Data selection
In India, the wholesale price index (WPI) is composed of 435 commodities and is available on a weekly basis with a short
time lag of two weeks. On the other hand, the consumer price index (CPI) is composed of only 260 commodities and is
Fig. 1. Spot rates and currency volatility.
3
We dene the currency volatility as the standard deviation, i.e., s

P
n
t1
e
t
e
2
=n 1
q
, where e is the daily spot rate. We estimate the currency
volatility from daily spot rates. In order to calculate the currency volatility, we take the 1st February 1999 as the base year. After calculating the monthly
currency volatility, we annualize it.
A. Aleem/ Journal of Asian Economics 21 (2010) 186197 188
available on a monthly basis with a time lag of one month. Due to these features of the WPI, it is the most widely used price
index in India by both analysts and policy makers to examine developing price trends and is generally considered as an
indicator of the inationary process in the economy. Therefore, we use the WPI as an index of domestic prices.
The analysis of monetary transmissionmechanisms is sensitive to the choice of interest rate used to capture the monetary
policy stance. Since the second half of the 1990s, the monetary transmission mechanism in India has been subject to many
changes in the operating procedures of monetary policy with proliferations of newinstruments. In April 1997, the bank rate
was reactivated as a reference rate to signal the stance of monetary policy. Variations in the bank rate provided signals to
commercial banks to modify their deposit and lending rates. In June 2000, the operationalization of the Liquidity Adjustment
Facility (LAF) set a corridor for the short-term interest rate through daily repo and reverse repo auctions. The liquidity was
absorbed at the reverse repo rate (oor), and the liquidity injection was done at the repo rate (ceiling). Fig. 3 depicts the
policy rates and money market rates in India. Asignicant decline in the volatility of the overnight call money rate since 2000
suggests that the system of LAF enabled the Reserve Bank to modulate short-term liquidity in order to ensure stable
conditions in the overnight call money market.
In the new monetary framework, the repo rate emerged as the major central bank renance rate. Beginning March 29,
2004, the entire central bank renance was made available at the repo rate, culminating in a complete de-linking of standing
facilities to banks frombank rate. While the systemof LAF was put in place in a phased manner without any disruption in the
market, the repo rate emerged as the lending rate of the Reserve Bank, replacing the bank rate for all practical purposes. Since
we use the data from1996Q4 to 2007Q4, the bank rate cannot be used to capture the monetary policy stance. However, if we
use the repo rate to capture the monetary policy stance, we are left with a very short time span. Although the policy rates
Fig. 2. Overnight call money rate and federal funds rate.
Fig. 3. Overnight call money rate and the LAF corridor.
A. Aleem/ Journal of Asian Economics 21 (2010) 186197 189
signal the stance of monetary policy, expectations about monetary policy stance are formed through the overnight call
money rate. Amonetary policy shock affects the short-terminterest rates. Following the changes in short-terminterest rates,
an entire range of monetary and nancial variables is affected. Consequently, the changes in the monetary and nancial
variables affect the aggregate demand. The overnight call money rate is the most closely watched variable in day-to-day
conduct of monetary operations. It has served as an informal operating target since the operationalization of the system of
LAF. In the context of the extent and timing of intervention in the money market, the overnight call money rate is preferred
over other short-term rates to capture the monetary policy stance. Previous empirical studies have used the overnight call
money rate to capture the monetary policy stance of the Reserve Bank of India. Singh and Kalirajan (2007) and Al-Mashat
(2003) used the overnight call money rate to capture monetary policy stance in order to examine monetary transmission in
the post-reformperiod. Kannan, Sanyal, and Bhoi (2006) used the overnight call money rate as a monetary policy instrument
to construct the monetary conditions index for India. Similarly, Virmani (2004) used the overnight call money rate as a
monetary policy instrument to estimate the monetary policy rules for India. Hence, we identify an unanticipated shock to the
overnight call money rate as an unanticipated monetary policy shock. An unanticipated shock to the overnight call money
rate is represented by overnight call money rate innovations, and the responses of other variables to these innovations are
represented by the structural impulse responses. In order to examine whether the overnight call money rate innovations
correspond to overnight call money rate shocks, we estimate the overnight call money rate innovations in percentage. Fig. 4
depicts the recovered overnight call money rate innovations and percentage quarterly growth of overnight call money rate.
We nd that the overnight call money rate innovations closely followthe quarterly growth of the overnight call money rate.
Hence, the recovered overnight call money rate innovations correspond to the policy actions of the Reserve Bank of India.
We performthe ordering of endogenous variables in Eq. (1) by focusing on the dynamic structure of the Indian economy.
Monetary policy shocks are orthogonal to the central banks information set. Considering the reaction function of the Reserve
Bank of India, we argue that the Reserve Bank takes into account the current stage of GDP and prices. Thus, the overnight call
money rate responds contemporaneously to shocks to GDP and prices. However, GDP and prices do not respond
contemporaneously to overnight call money rate shocks.
We use the quarterly seasonally adjusted data from 1996Q4 to 2007Q4. Although some variables appear to be non-
stationary, we estimate the VAR model in levels. Sims, Stock, and Watson (1990) demonstrated that a VAR model in levels
incurs some loss in estimators efciency but not consistency. The objective of estimating a VAR model in levels is to examine
the relationship among variables, not to determine efcient estimates. Previous studies on monetary transmission
mechanisms have estimated the VAR models in levels.
4
Since GDP and prices are log transformed, their impulse responses to
a monetary policy shock are explained as a proportion of the baseline level. The optimal lag length under various criteria
seems to be one quarter. However, we feel that this is too short for quarterly data. Hence, we use two lags.
5
3.3. Results of the benchmark model
Fig. 5 depicts the dynamic responses of GDP, prices and overnight call money rate to a positive one standard deviation
overnight call money rate shock. An unanticipated tightening of monetary policy corresponding to a rise of 1.5% in the
Fig. 4. Structural innovations versus growth in overnight call money rate.
4
Favero (2004) also argued that VAR models of monetary transmission mechanisms are very rarely cointegrated VARs. Imposing cointegration
restrictions on a VAR model in levels gives more efcient estimators, but at the cost of potential inconsistency due to the imposition of incorrect identifying
restrictions.
5
The use of too many lags may create the degrees of freedom problem. Ramasway and Sloek (1997), Morsink and Bayoumi (2001), Al-Mashat (2003),
Disyatat and Vongsinsirikul (2003) have used two lags in quarterly estimations of monetary transmission mechanisms in the European Union, Japan, India
and Thailand, respectively Ramaswamy and Sloek (1997).
A. Aleem/ Journal of Asian Economics 21 (2010) 186197 190
overnight call money rate creates a decline in GDP. GDP bottoms out in the third quarter and shows a V-shaped response.
Prices also decline in response to a positive overnight call money rate shock. The maximum decline in prices is achieved in
the third quarter at 0.1% below the baseline. The price-puzzle disappears after the inclusion of the vector of exogenous
variables. The overnight call money rate falls initially to 0.22% belowthe baseline, but then it converges toward the baseline.
This suggests that an unanticipated monetary policy shock has temporary effects on the overnight call money rate. The
dynamic impulse responses also show that the prices start declining after the decline in GDP.
4. Monetary transmission channels
In order to examine the monetary transmission channels in India, we augment the benchmark VAR model by including a
new variable w corresponding to the respective monetary transmission channel. We assume that w responds
contemporaneously to shocks to GDP, prices and overnight call money rate. However, GDP, prices and overnight call money
rate do not respond contemporaneously to a shock to w. Thus, we write the vector of endogenous variables as follows:
Y
0
t
GDP prices i w
We estimate Eq. (1) to obtain the impulse response of GDP to an unanticipated positive overnight call money rate shock.
Then, we exogenize wby treating its lagged values as exogenous variables. Thus, we block off all interactions between wand
the other endogenous variables.
6
After exogenizing w, the vector of endogenous variables (Y
0
t
) is written as follows:
Y
0
t
GDP Prices i
and the vector of exogenous variables is written as follows:
X
0
t

Compi
world
i
us
y
us
w1 wp
h i
where p represents the number of lags. Thus, by exogenizing win this way, we obtain a newVAR model similar to the original
one. The two VAR models are characterized by similar orthogonalized innovations. The only difference is that in the latter we
block off the responses that pass through w. After exogenizing w, we estimate the impulse responses of GDP to a positive
overnight call money rate shock. We examine each channel by comparing the impulse responses of GDP in the two VAR
models.
4.1. Bank lending channel
The bank lending channel relies on two conditions. First, the central bank controls bank lending through its monetary
policy instrument. Second, there is no alternative to bank lending, at least for some sectors of borrowers (Barran, Coudert, &
Mojon, 1996). Until 1996, the Reserve Bank of India used only the quantity instruments to control the amount of bank loans.
Among these instruments were the cash reserve ratio (CRR) and the priority sector lending targets. The objective of priority
sector lending targets was to meet the governments development goals. Since 1997, the Reserve Bank of India has used the
price instruments to control indirectly the amount of bank loans. However, the Reserve Bank still uses the priority sector
lending targets.
India is a bank-based economy characterized by a predominance of bank nancing. Since 2005, the bank credit to the
commercial sector has accounted for more than 70% of total domestic credit. Fig. 6 shows a comparison of bank credit to
Fig. 5. Benchmark VAR model: impulse responses to a positive overnight call money rate shock.
6
Morsink and Bayoumi (2001) and Disyatat and Vongsinsirikul (2003) have used this methodology to examine the monetary transmission mechanisms
in Japan and Thailand, respectively. Since we include the vector of exogenous foreign variables in our VAR model, our identication scheme differs from
theirs.
A. Aleem/ Journal of Asian Economics 21 (2010) 186197 191
commercial sector and domestic credit in India. The bank credit to commercial sector as percentage of GDP has increased
from 0.6% in 1998 to 1.2% in 2007. This suggests an increasing importance of the banking sector in the Indian economy. The
importance of bank lending in the nancial systemrepresents the lack of alternative sources of funding for the private sector.
Fig. 7 depicts the currency to deposit ratio
7
in India. This ratio declined from10.9 in 1999 to 8.7 in 2007. A gradual decline
in the currency to deposit ratio since 1999 suggests an increasing role of banks in nancial intermediation.
In the bank lending channel, our focus is on the magnication of the effects of an unanticipated monetary policy shock
that passes through bank loans. In the standard IS-LM framework, a monetary policy tightening reduces the supply of
deposits. A shortage of the supply of deposits creates an increase in the interest rate on bonds. Consequently, an inward
movement of the LMcurve results in a decline in investment and aggregate demand. This mechanismis commonly known as
the money channel. However, in the bank lending channel the effects of a monetary policy tightening are further propagated
through changes in bank lending. In the bank lending channel, the interest rates on bonds and loans determine investment
and aggregate demand. Thus, a monetary policy tightening reduces not only the supply of deposits, but also the supply of
credit. A shortage of the supply of credit creates an increase in the interest rate on loans. Consequently, there is a further
decline in investment and aggregate demand. Thus, the response of GDP to a monetary policy tightening is larger in the bank
lending channel than in the money channel. In order to examine the importance of the bank lending channel, we proceed in
three steps. First, we examine the response of the interest rate on loans to a monetary policy tightening. Second, we examine
the effects of a monetary policy tightening on bank loans. Third, given that a monetary policy tightening reduces the
aggregate demand, we examine how much of the effects of monetary policy tightening passes through bank lending. The
third step tells us about not only the presence of the bank lending channel, but also its importance in the propagation of
monetary policy shocks.
Fig. 7. Currency to deposit ratio.
Fig. 6. Indicators of bank lending.
7
We dene the currency to deposit ratio as the ratio of currency in circulation to demand deposits plus time deposits held by the banks.
A. Aleem/ Journal of Asian Economics 21 (2010) 186197 192
We examine the effects of a positive overnight call money rate shock on the prime lending rate (PLrate) by using the
following vector of endogenous variables:
Y
0
t
GDP Prices i PLrate
Fig. 8 depicts the dynamic responses of the prime lending rate to an unanticipated positive overnight call money rate shock.
The prime lending rate responds immediately to an overnight call money rate shock. A positive overnight call money rate
shock creates an initial increase in the prime lending rate to 0.24% above the baseline. After the second quarter, it converges
toward the baseline.
In order to examine the effects of monetary policy tightening on bank loans and GDP in the bank lending channel, we
include the bank credit to the commercial sector. Thus, the vector of endogenous variables consists of GDP, prices, overnight
call money rate and bank credit to commercial sector (loans):
Y
0
t
GDP Prices i Loans
Fig. 9 depicts the dynamic responses of bank loans, prices and GDP to an unanticipated positive overnight call money rate
shock. The quantity of bank loans to the commercial sector decreases initially to 0.57% below the baseline in response to a
monetary policy tightening. Prices show a similar response to a monetary policy tightening.
The solid line in the right panel of Fig. 9 represents the impulse responses of GDP to positive overnight call money rate
innovations in the bank lending channel. GDP bottoms out in the third quarter at 0.27% below the baseline. In order to
calibrate the importance of the bank lending channel in the transmission of monetary policy shocks, we re-estimate the
model after exogenizing the bank loans. After exogenizing the bank loans, the model represents the traditional money
channel where there is no role of bank lending and the monetary policy shocks are transmitted to the real sector in the
standard IS-LM framework. The dashed line in the right panel of Fig. 9 represents the response of GDP to positive overnight
call money rate innovations after exogenizing the bank loans. The response of GDP to positive overnight call money rate
innovations is signicantly reduced after exogenizing the bank loans. At the beginning of the second year, 70% of the impact
of monetary policy tightening comes from bank loans. When we blocked off the channel, the accumulated response of GDP
was reduced by 66% in twelve quarters. This difference between the two responses of GDP to positive overnight call money
rate innovations suggests the importance of the bank lending channel in India.
Fig. 9. Bank lending channel: impulse responses to a positive overnight call money rate shock.
Fig. 8. Response of prime lending rate to a positive overnight call money rate shock.
A. Aleem/ Journal of Asian Economics 21 (2010) 186197 193
4.2. Asset price channel
Monetary policy shocks are transmitted to asset prices, which subsequently affect the GDP and prices. The degree of
capital market development in a country can be examined by observing different parameters such as market capitalizationof
listed companies, listed stocks and trading volume. Fig. 10 shows that after 2003, the market capitalization of listed
companies increased signicantly in India. However, it remains lower as compared to developed countries. This suggests
that the capital markets in India are not sufciently developed and that the asset price channel is not signicant.
We examine the asset price channel by using the following vector of endogenous variables.
Y
0
t
GDP Prices i SEI
where SEI is the stock exchange index. We use the SENSEX-30 as an index of stock exchange. SENSEX-30 is the index of the
Bombay Stock Exchange. It is a widely reported index in both domestic and international markets. It is a basket of thirty
constituent stocks representing a sample of large liquid and representative companies.
Fig. 11 depicts the impulse response of GDP to a positive overnight call money rate shock. A positive overnight call money
rate shock creates a decline in GDP. GDP bottoms out in the fourth quarter at 0.19% below the baseline. When we exogenize
the SENSEX-30, GDP shows almost a similar response to a positive overnight call money rate shock. At the beginning of the
second year, only 25% of the effects of monetary policy tightening pass through the asset prices. After blocking off the
channel, the accumulated response of GDP is reduced by only 24% in twelve quarters. These results suggest that the asset
price channel is not important in the transmission of monetary shocks to the real sector in India.
4.3. Exchange rate channel
The importance of the exchange rate channel in the transmission of monetary shocks depends on the nature of the
exchange rate regime and the degree of openness of the economy. In order to examine the exchange rate channel, we divide
the response of the real sector to an interest rate shock into two steps. The rst step describes the reaction of the exchange
Fig. 11. Asset price channel: impulse responses to a positive overnight call money rate shock.
Fig. 10. Market capitalization of listed companies (% of GDP).
A. Aleem/ Journal of Asian Economics 21 (2010) 186197 194
rate to an interest rate shock. The reaction of the exchange rate to an interest rate shock depends on the nature of the
exchange rate regime. In a free oating exchange rate regime, the exchange rate reacts more pronouncedly to an interest rate
shock. However, if the exchange rate is pegged or heavily managed, it will not respond to the interest rate shock. The second
step describes the reaction of the economy to variations in the exchange rate. The response of the real sector to variations in
the exchange rate depends positively on the degree of openness of an economy.
Since 1993, the ofcial exchange rate regime in India has been the market-determined exchange rate regime. However,
frequent interventions by the Reserve Bank of India to stabilize the movements of the Indian rupee vis-a` -vis the US dollar
showthat the de facto exchange rate regime is different fromthe de jure exchange rate regime and the Indian rupee seems to
be pegged to the US dollar.
8
According to the IMF classication of de facto exchange rate regimes in 2006, India has a de facto
managed oating regime with an unannounced path of exchange rate (International Monetary Fund, 2006). In 2006, the
committee on fuller capital account convertibility afrmed the recommendations of the 1997 committee to the Reserve Bank
of India, recommending that the Reserve Bank should maintain a monitoring band of 5% around the real effective exchange
rate and should intervene as and when the real effective exchange rate moves outside of this band (Reserve Bank of India, 2006).
According to these recommendations, the Reserve Bank of India can use its judgment to intervene even within the band to
preclude speculative forces and unwarranted volatility. The committee further recommended that the Reserve Bank of India
should undertake a periodic review of the real effective exchange rate, which can be changed as warranted by fundamentals.
Moreover, ensuring orderly conditions in the foreign exchange market to avoid excessive exchange rate volatility is one of the
objectives of Indian monetary policy. Frequent interventions by the Reserve Bank of India to stabilize the exchange rate weaken
the exchange rate channel. Moreover, the large size of the Indian domestic market as compared to its total exports or imports also
suggests that the exchange rate channel is not important in the transmission of monetary policy shocks to the real sector.
In order to examine the exchange rate channel, we focus on the effects of a positive overnight call money rate shock on
GDP that passes through the exchange rate. The vector of endogenous variables consists of GDP, prices, overnight call money
rate and real effective exchange rate (REER).
Y
0
t
GDP Prices i REER
Fig. 12 depicts the responses of GDP, prices and real effective exchange rate to positive innovations in the overnight call
money rate and real effective exchange rate. In response to an unanticipated increase in the overnight call money rate, the
real effective exchange rate appreciates initially and shows a short-lived reaction to a positive overnight call money rate
shock. The effects of a positive overnight call money rate shock on the real effective exchange rate almost disappear in the
sixth quarter. A weak response of the real effective exchange rate to a positive monetary policy shock weakens the rst step
in the exchange rate channel. These results also suggest that the Reserve Bank of India tends to stabilize the real effective
exchange rate.
The right panel of Fig. 12 shows the responses of GDP to overnight call money rate innovations with and without real
effective exchange rate exogenized. In the two cases, the GDP responds to positive overnight call money rate innovations
almost in a similar way. These results suggest the absence of an exchange rate channel in India.
4.4. Robustness of results
The empirical results in the augmented VAR models suggest the importance of the bank lending channel in India. In order
to check the robustness of these empirical results, we examined their statistical signicance. We estimated 2S.E. condence
intervals after blocking off each channel. Fig. 13 depicts the impulse responses of GDP to a positive overnight call money rate
shock within the channel and after blocking off the channel with 2S.E. condence intervals.
Fig. 12. Exchange rate channel: impulse responses to a positive overnight call money rate shock.
8
Similarly, Reinhart and Rogoff (2002) found that from July 1995 to December 2001, India had a de facto crawling peg to the US dollar.
A. Aleem/ Journal of Asian Economics 21 (2010) 186197 195
We nd that the responses of GDP to a positive overnight call money rate shock are statistically signicant in the bank
lending channel. However, GDP shows similar responses to a positive monetary policy shock in the asset price and exchange
rate channels. These estimates suggest the robustness of our empirical results and validate the importance of the bank
lending channel in India.
5. Conclusion
The existence of external constraints on monetary policy in emerging economies requires a model specication different
from that of developed countries. This paper provides a comprehensive empirical analysis of the monetary transmission
mechanism in India. We estimated a series of VAR models to examine three transmission channels of monetary policy. The
benchmark VAR model is composed of a vector of endogenous domestic variables and a vector of exogenous foreign
variables. We imposed restrictions on the contemporaneous effects of endogenous variables to have an exact identication
of the benchmark VAR model. The results of the benchmark VAR model suggest that an unanticipated monetary policy shock
has transitory effects on the overnight call money rate. The price-puzzle vanished after the inclusion of the vector of
exogenous foreign variables. Prices and GDP decline after an unanticipated positive overnight call money rate shock.
Moreover, prices start declining after a decline in GDP.
The Indian economy is a bank-based economy. Since 2005, bank credit to the commercial sector has accounted for more
than 70% of total domestic credit. The currency to deposit ratio has declined continuously since 1999. These facts suggest
that the banks play an important role in nancial intermediation and that the non-nancial sector lacks alternative sources
of funding. Our empirical results support the importance of the bank lending channel in the transmission of monetary policy
shocks to the real sector.
The lower market capitalization of listed companies in India as compared to developed countries suggests that the capital
markets in India are not sufciently developed. Empirical estimates in the augmented VAR model suggest that the asset price
channel is not important in the transmission of monetary policy shocks to the real sector in India. Central banks in emerging
economies stabilize exchange rates even though they announce that they do not do so. Massive interventions by the Reserve
Bank of India in the foreign exchange market to stabilize the exchange rate weaken the exchange rate channel. The short-
lived response of the real effective exchange rate to an unanticipated monetary policy tightening suggests that the exchange
rate channel is not important in the transmission of monetary policy shocks in India.
This analysis provides some important theoretical and policy implications. First, Indian monetary policy is constrained by
the Feds monetary policy. Hence, an analysis of Indian monetary policy requires the inclusion of the federal funds rate in the
information set of the Reserve Bank of India. A proper model specication, considering the external constraints on monetary
policy and controlling for international economic events, reduces the bias. Second, the Reserve Bank of India intervenes
massively in the foreign exchange market to stabilize the exchange rate. The Indian rupee seems to be pegged to the US
dollar. Hence, a proper comprehension of the monetary transmission mechanism in India requires the analysis not only of
the response of GDP, but also of the response of the exchange rate to a monetary policy shock. Third, banks play an important
role in nancial intermediation in the Indian economy, and their strong representation reects the lack of alternative sources
of funding for the private sector.
Appendix A. Data sources
Overnight call money rate, bank rate, repo rate, reverse repo rate, bank credit to commercial sector, currency in circulation,
time deposits, demand deposits: Reserve Bank of India; and Reuters.
Wholesale Price Index, federal funds rate, GDP of the United States and India: International Monetary Fund, International
Financial Statistics.
Fig. 13. Response of GDP to a positive overnight call money rate shock.
A. Aleem/ Journal of Asian Economics 21 (2010) 186197 196
Sensitive index (BSE-30), spot rates: Reuters; and Eurostat.
Real effective exchange rate: The Bank for International Settlements.
Prime lending rate: OECD.
World commodity price index: The economist.
Market capitalization of listed companies: World Bank, World Development Indicators.
References
Ahmed, N., Hastam, S., Asif, A. I., & Yasir, M. A. (2005). Transmission mechanism of monetary policy in Pakistan. SBP research bulletin, Vol. 1, No. 1, State Bank of
Pakistan.
Al-Mashat, R. (2003). Monetary policy transmission in India: Selected issues and statistical appendix. Country report no. 03/261. International Monetary Fund.
Barran, F., Coudert, V., & Mojon, B. (1996). The transmission of monetary policy in European countries. Working paper no. 96-03. Paris: CEPII.
Bernanke, B., & Blinder, A. (1988). Credit, money and aggregated demand. The American economic review, papers and proceedings of the one-hundredth annual
meeting of the American economic association, Vol. 78 (pp. 435439).
Bernanke, B., & Blinder, A. (1992). The Federal funds rate and the channels of monetary transmission. The American Economic Review, 82, 901921.
Calvo, G., & Reinhart, C. (2000). Fear of oating. NBER working paper no. 7993. Cambridge: National Bureau of Economic Research.
Christiano, L. J., Eichenbaum, M., & Evans, C. (1998). Monetary policy shocks: What have we learned and to what end? NBER working paper no. 6400. Cambridge:
National Bureau of Economic Research.
Disyatat, P., & Vongsinsirikul, P. (2003). Monetary policy and the transmission mechanism in Thailand. Journal of Asian economics, 4, 389418.
Favero, C. A. (2004). Applied macroeconometrics. Oxford University Press. pp. 162211.
International Monetary Fund. (2006, July). De facto classication of exchange rate regimes and monetary policy framework. IMF. Available on http://www.imf.org/
external/np/mfd/er/2006/eng/0706.htm.
Kannan, R., Sanyal, S., & Bhoi, B. (2006, Winter). Monetary conditions index for India. Reserve Bank of India occasional papers 27, no. 3.
Levy-Yeyati, E., & Sturzenegger, F. (2005). Classifying exchange rate regimes: Deeds vs. words. European Economic Review, 49, 16031635.
Morsink, J., & Bayoumi, T. (2001). A peek inside the black box: The monetary transmission mechanismin Japan. IMF staff papers, Vol. 48, International Monetary Fund.
pp. 2257.
Pandit, B. L., Mittal, A., Roy, M., & Ghosh, S. (2006). Transmission of monetary policy and the bank lending channel: Analysis and evidence for India. Study number 25,
Mumbai: Development Research Group, Department of Economic Analysis And Policy, Reserve Bank of India.
Peersman, G., & Smets, F. (2001). The monetary transmission mechanism in the euro area: More evidence from VAR analysis. Working paper no. 91. Germany:
European Central Bank.
Prasad, A., & Ghosh, S. (2005). Monetary policy and corporate behaviour in India. IMF working paper no. 05/25. International Monetary Fund.
Ramaswamy, R., & Sloek, T. (1997). The real effects of monetary policy in the European Union: What are the differences? IMF working paper 97/160.
Reinhart, C., & Rogoff, K. (2002). Modern history of exchange rate arrangements: A reinterpretation. NBER working paper no. 8963. Cambridge: National Bureau of
Economic Research.
Reserve Bank of India. (2003, March). Money, credit and prices. Report on currency and nance. Mumbai: Reserve Bank of India.
Reserve Bank of India. (2004, December). Monetary transmission mechanism. Report on currency and nance 2003-04 (pp. 171193). Mumbai: Reserve Bank of
India.
Reserve Bank of India. (2006, July). Chapter 5: Interaction of monetary policy and exchange rate policy. Report of the committee on fuller capital account
convertibility.
Sims, C. (1992). Interpreting the macro-economic time series facts: The effects of monetary policy. European Economic Review, 36, 9751011.
Sims, C., Stock, J. H., & Watson, M. W. (1990). Inference in linear time series models with some unit roots. Econometrica, 58, 113144.
Singh, K., & Kalirajan, K. (2007). Monetary transmission in post-reform India: An evaluation. Journal of Asia pacic economy, 12, 158187.
Suzuki, T. (2004). Credit channel of monetary policy in Japan: Resolving the supply versus demand puzzle. Applied Economics, 36, 23852396.
Virmani, V. (2004). Operationalizing Taylor-type rules for the Indian economy: Issues and some results (1992Q2001Q1). IIMA working paper no. 2004-07-04.
A. Aleem/ Journal of Asian Economics 21 (2010) 186197 197